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Monetary Policy and the Cyclicality of Risk

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  • Gust, Christopher
  • López-Salido, J David

Abstract

We use a DSGE model that generates endogenous movements in risk premia to examine the positive and normative implications of alternative monetary policy rules. As emphasized by the microfinance literature, variation in risk arises because households face fixed costs of transferring cash across financial accounts, implying that some households rebalance their portfolios infrequently. We show that the model can account for the mean returns on equity and the risk-free rate, and in line with empirical evidence generates a decline in the equity premium following an unanticipated easing of monetary policy. An important result that emerges from our analysis is that countercyclical monetary policy generates higher average welfare than constant money growth or zero inflation policies.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7727.

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Date of creation: Mar 2010
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Handle: RePEc:cpr:ceprdp:7727

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Keywords: countercyclical equity premium; monetary policy; portfolio inertia; segmented markets;

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References

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  1. Aubhik Khan & Julia Thomas, 2007. "Inflation and interest rates with endogenous market segmentation," Working Papers 07-1, Federal Reserve Bank of Philadelphia.
  2. John B. Taylor, 1999. "Monetary Policy Rules," NBER Books, National Bureau of Economic Research, Inc, number tayl99-1.
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  17. Francisco Palomino, 2012. "Bond Risk Premiums and Optimal Monetary Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 15(1), pages 19-40, January.
  18. Jonathan A. Parker & Annette Vissing-Jorgensen, 2009. "Who Bears Aggregate Fluctuations and How?," NBER Working Papers 14665, National Bureau of Economic Research, Inc.
  19. Markus K. Brunnermeier & Stefan Nagel, 2006. "Do Wealth Fluctuations Generate Time-varying Risk Aversion? Micro-Evidence on Individuals' Asset Allocation," NBER Working Papers 12809, National Bureau of Economic Research, Inc.
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  1. Monetary policy and the cyclicality of risk
    by Christian Zimmermann in NEP-DGE blog on 2010-08-17 14:28:19

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